Monday, July 12, 2010

A circuit court in Virginia was faced with the question of whether a Limited Liability Company can sue one of its three Members when, under the LLC’s Operating Agreement, the decision to file a law suit required that all three Members agree, including the Member being sued. For obvious reasons, no Member would vote to be sued. The case is Infinite Design Electric Assoc. LLC, et al. v. Donald R. Hague, 2010 Va. Cir. LEXIS 27 (Fairfax Cir. Ct. 2010).

The question presented the court with a classic legal dilemma by arguably pitting a just outcome against a technical legal interpretation that would deprive the aggrieved party of a remedy.

The LLC member being sued in the Infinite Design case allegedly engaged in the unfair business practices of forming a competing company, courting the existing LLC's clients using that LLC's "client lists, estimate strategies, and proposal forms to out maneuver [the existing LLC] and steal its clients."

In reaching its decision, the court could have framed the legal question in a number of different ways, but chose to ask: "Should a manager of an LLC be able to hold the entity hostage when it is the bad acts of that manager that the LLC seeks to redress?" The problem for the court in answering that question is that it found "no Virginia statutory or case law directly on point with this situation . . . ." Thus, the court looked to “analogous authority from Virginia and other states."

But the court looked to more than just analogous statutes, relying instead on other states' statutes that have no parallel in the Virginia Code; finding that "Pennsylvania does not allow interested managers to vote to sue if that manager has 'an interest in the outcome of the suit that is adverse to the interest of the company.' 15 Pa.C.S. § 8992(2) (2009). New York's LLC act precludes managers of LLCs from transacting with the LLC when that manager has a 'substantial financial interest' in the transaction. NY CLS LLC § 411 (2010)." The decisions of the Pennsylvania and New York legislative bodies, however, may have no bearing on how Virginia's General Assembly might address that issue in the future.

The court also relied upon a 1937 Virginia Supreme Court case that "suggests that the vote of a director of a corporation who has a personal interest in a matter is not to be counted in relation to that matter," citing Crump v. Bronson, 168 Va. 527, 537, 191 S.E. 663 (1937). The court's use of the word "suggests" is apt because the Court in Crump faced the question of whether an interested director could be used to constitute a quorum under the old Code requirement that every corporation have at least three directors. Now, however, there are many single member LLCs where the member is necessarily an interested director for any vote pertaining to the member’s compensation and rights.

The third leg supporting the Court's decision was the LLC's incorporation of Virginia Code § 13.1-1024.1 that "requires managers to carry out their duties with 'good faith business judgment [that is in] the best interest of the [LLC].'" The incorporation of this section, according to the court, was a clear reflection of the LLC’s "intention to hold managers' actions to a certain standard. A manager would never vote to authorize a suit against himself, but bringing suit is the only course of action an LLC ca[n] take in the case of manager misconduct."

For those reasons, the court held that the LLC "did not need unanimous approval of the managers to bring suit when the suit was intended to be brought against one of its managers. Such a reading of the Operating Agreement would amount to a situation of 'suicide by operating agreement', and would paralyze the LLC from remedying any suspected malfeasance by one of its managers."

The court, however, did not address several countervailing Virginia Code sections and legal principles. First, Virginia Code § 13.1-1002 defines an "Operating agreement" as “an agreement of the members as to the affairs of a limited liability company and the conduct of its business . . . ." Second, § 13.1-1001.1.C. provides that the Virginia Code sections governing LLCs "shall be construed in furtherance of the policies of giving maximum effect to the principle of freedom of contract and of enforcing operating agreements." (Emphasis added.) Third, § 13.1021.A.1. states that "A limited liability company is bound by its operating agreement whether or not the limited liability company executes the operating agreement. An operating agreement may contain any provisions regarding the affairs of a limited liability company and the conduct of its business to the extent that such provisions are not inconsistent with the laws of the Commonwealth or the articles of organization."

In addition, a significant body of Virginia case law arguably dictates a different result. In a decirion also coming out of Fairfax County Circuit Court, Coker v. State Farm Fire & Cas. Co., 45 Va. Cir. 510 (Fairfax Cir. Ct. 1998), the court explained that it was "precluded from rewriting a contract between two parties, quoting a series of Virginia Supreme Court cases that state: "It is not the province of this Court to rewrite contractual language. Rather, it is incumbent upon courts to construe the language drafted by the parties."; "It is the function of the court to construe the contract made by the parties, not to make a contract for them."; "Courts will not rewrite contracts; parties to a contract will be held to the terms upon which they agreed."; "A court is not at liberty to rewrite a contract simply because the contract may appear to reach an unfair result." (Citations omitted.)

Finally, there are economic consequences to the LLC and the member being sued. Both the LLC and the member hired their respective attorneys. The member being sued, however, has to pay his pro rata share for both the LLC’s lawyer and his own lawyer, even if the member prevails at trial.

The Infinite Design court's decision to rewrite the operating agreement, if followed, presents future courts with the question of which circumstances justify rewriting operating agreements or other corporate documents. Although courts will invariably try to limit those circumstances, those attempts will be more difficult if courts frame the question like the Infinite Design court and ask: "Should a manager of an LLC be able to hold the entity hostage when it is the bad acts of that manager that the LLC seeks to redress?" For instance, the member being sued might vote against the LLC entering into profitable contracts to starve the LLC, thereby making it impossible for the LLC to pay for its attorneys. Would the court then waive the unanimous consent requirement and contractually bind the LLC against one member’s interests?

It will be interesting to track whether the Infinite Design decision gets appealed to the Virginia Supreme Court, or whether other Virginia Circuit Courts follow or extend it.

Tuesday, July 6, 2010

Your Virginia company has been damaged by unfair business activities of another individual or business that is located outside of Virginia. You file a multi-count suit in federal court alleging both breach of contract and tort causes of action based upon diversity of citizenship. The defendant moves to dismiss the suit on the basis that the court lacks personal jurisdiction over the nonresident defendant for some, if not all of the counts. What test does the court employ in resolving that motion?

Under the Constitution, a court may exercise personal jurisdiction over an out of state defendant in two situations: (1) where the defandant has "systematic and continuous" contacts with the forum state; or (2) where the contacts with the forum state "give rise to the liabilities sued on." International Shoe v. State of Washington , 326 U.S. 310,317,320 (1945). The first situation is referred to as "general jurisdiction," It is a hard test to meet and generally requires significant contacts over a period of several years. Most cases proceed based upon the second situation that is referred to as "specific jurisdiction."

A threshold question where "specific jurisdiction" is alleged, is whether, once a plaintiff proves minimum contacts with the forum state related to one cause of action, he may add other claims to the suit that do not arise out of those contacts? For example, assume that the parties negotiated and executed a contract in Virginia and the plaintiff sues in Virginia for breach of that contract. But in addition to that count, the plaintiff adds tort counts that are based upon actions that took place in the state where the defendant is located. The plaintiff asserts that the effects of those actions were felt in Virginia. Can all of the claims constitutionally proceed in Virginia where the action was filed? The Fourth Circuit Court of Appeals has never directly addressed these issues. Recently, a district court in the Eastern District of Virginia did.

In Gatekeper. Inc. v. Stratech Systems, Ltd., 2010 U.S. Dist. LEXIS 56625 (June 9, 2010), click here, the district court found that "specific jurisdiction" requires proof that the defendant's contacts with the forum state give rise to each claim alleged in the complaint. Thus, using the example above, it is the plaintiff's burden to demonstrate that each tort claim is supported by the requisite minimum contacts with Virginia. That there werd sufficient contacts to support the breach of contract claim is not enough to save the tort claims. According to the court, if the plaintiff cannot meet that requirement, the unsupported claims must be dismissed for lack of personal jurisdiction. Moreover, that the effects of the bad acts were felt in Virginia, while relevant, is not dispositive.

This is an important decision, not only in the Eastern District of Virginia, but throughout the Fourth Circuit, given that it is a matter of first impression in this Circuit.